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Innovation in the ETF industry has become standard over the past several years, with countless first-to-market products opening up new asset classes and strategies. And it turns out that the U.S. isn’t the only place where product development is going full throttle; our neighbors to the north have recently rolled out some rather unique exchange-traded products.

Horizons, one of the largest Canadian issuers of ETFs, recently debuted a suite of Black Swan ETFs that are designed to protect investors against sudden plunges in equity markets. The new ETFs, including the Horizons Universa Canadian Black Swan ETF (HUT) and Horizons Universa U.S. Black Swan ETF (HUS) will combine traditional exposure to stock indexes with an actively-managed options strategy. The goal of these products is to protect assets in the event of extreme downside events–such as a wave of sovereign debt defaults in Europe [sign up for the free ETFdb newsletter].

Black Swan Basics

The term “black swan” is used to describe unexpected events that have a major impact on society, and are rationalized after the fact. Generally, black swans are events that are presumed to be impossible but eventually shown to be within the realm of possibility. It was once assumed that black swans did not exist, since they had never before been observed. When a black swan was first spotted, however, the hypothesis that these creatures did not exist was immediately disproven.

The idea of Black Swan events became well-known as a result of the 2004 book Fooled By Randomness, which was written by Nassim Nicholas Taleb. The author has asserted that Black Swan events: 1) are unexpected, 2) have a major impact, and 3) are rationalized in hindsight as if it could have been expected.

Taleb’s book did not suggest that investors should attempt to predict Black Swan events, but rather to establish systems to protect themselves from their occurrence [see the Black Swan Hyperinflation ETFdb Portfolio].

Black Swan ETFs

The new Black Swan ETFs essentially consist of two components: exposure to broad stock indexes such as the S&P 500 or S&P/TSX 60 and a pool of put and call options that utilizes the Black Swan Protection Protocol. The basket of options will be actively managed by Universa Investments, which was founded by Mark Spitznagel. Universa made a fortune by betting against stock markets in 2008; Spitznagel’s fund returned more than 100% in 2008 as global stock markets tumbled.

Nassim Taleb serves as a Distinguished Scientific Advisor for Universa.

The idea behind the options pool is to assemble protection in the event that stocks plunge, with the goal of offsetting the losses incurred by the traditional long only position. That can potentially be done by simply buying put options that will be valuable if stock markets decline, or selling call options that will expire worthless in the event of a sharp decline. The goal is to generate positive returns from the options pool when stocks decline, with gains invested into equity markets when they are cheap on a historical basis–consistent with a “buy low” strategy.

The strategy essentially is intended to dramatically reduce downside risk taken on by investors. In exchange, the Black Swan ETFs may give up some upside potential when stocks are rallying. For example, the premiums paid to buy put options on the S&P 500 could erode returns if they expire worthless.

Big declines in equity market may be more common than some investors realize; both the S&P 500 and TSX 60 have experienced steep sell-offs numerous times historically:

Severe Monthly Losses

Number of S&P/TSX 60™ Index rolling monthly losses over the last 20 years

Number of S&P 500®Index rolling monthly losses over the last 50+ years

-20.00

5

6

-22.00

2

6

-24.00

2

6

-26.00

2

4

-28.00

1

3

-30.00

0

0

Total

12

25

A “Black Swan Overlay” could potentially bring significant value by eliminating a significant portion of the downside risk. The following graph from the Horizons Web site shows hypothetical performance in some extreme environments:

ETF Database

Assumes Portfolio A invests $100 in a stock index ETF, while Portfolio B invests $99 in a stock index ETF and $1 in the Black Swan Protection Protocol options strategy.